How ETNs Can Save Taxes Over ETFs

Given the tracking and tax problems surrounding ETFs such as United States Natural Gas (UNG), United States Oil (USO), and many others, it might be worth revisiting the infamous exchange traded note(ETN) structure instead.

ETNs are basically bonds that pay investors a cash pay-out when an investor wants them redeemed. This pay-out is related to the performance of some index, such as the S&P500.

While high profile losses by investors in some Lehman ETNs destroyed their popularity, ETN's have advantages over ETFs when it comes to A) tracking a benchmark and B) taxes.

First of all, ETN returns are usually calculated as simply your benchmark's performance minus fund expenses.

For example, this avoids the mess of an ETF having to roll into all kinds of futures positions, trying to track say natural gas, to the detriment of investor performance.

Savvy traders can't game ETNs as they do for ETFs either. (As far as we know)

Yet ETNs really start to outshine their ETF competitors when it comes to taxes:

Index Universe: But the real advantage of commodity ETNs was (and remains) their tax treatment. The prospectus said (and still says) that ETNs can be treated basically like zero-dividend stocks for tax purposes. If you hold a commodity ETN for longer than a year, you only pay 15 percent long-term capital gains taxes when you sell. What's more, you don't have to pay any taxes until you sell.

By comparison, futures-based commodity ETFs like the PowerShares DB Commodity ETF (NYSEArca: DBC) are treated like futures by the IRS. That means that gains are marked-to-market each year, and investors must pay taxes on those gains at a blended 60 percent/40 percent long-term/short-term capital gains tax rate. For a high-earning investor, that puts the blended tax rate at 23 percent, payable every year.

That's a huge difference. An ETN investor pays a 15 percent tax rate, deferrable until the ETN is sold; the ETF investor pays a 23 percent tax rate, due annually.

There's one major risk though, and this is why the credit crisis scared people away from the ETN structure.

Investors are exposed to the credit risk of whichever bank issues the ETN in question.

Index Universe: The N in ETN stands for note, and that's what they are: unsecured debt notes. Like any other uninsured promise-to-pay, their entire value depends on the credit of the issuing bank. If you buy a Deutsche Bank ETN and Deutsche Bank goes bankrupt, you lose all your money.

It's not a theoretical fear. The very few people who held the three Lehman Brothers ETNs to the bitter end lost their money when the firm went bankrupt. It's obvious, looking at the numbers, that the credit crisis stopped the growth of ETNs in their tracks.

But let's be honest: For an investor who is paying attention, the likelihood of losing money in an ETN is vanishingly small. Most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.

So ask yourself: How likely is it that Barclays Capital or Deutsche Bank, or whomever is underwriting a particular ETN, will go bankrupt with less than 48 hours' warning? Or to put a margin of safety on it, how likely is it that they will go bankrupt in the next week?

A lot of due diligence is required for any investment, and the universe of ETNs remains limited. Yet their tax and tracking benefits might outweigh the credit risk attached to these investments, because the dirty secret of somes ETFs is that their taxes can really kill you over long periods of time.